CAPITAL BUDGETING AND

VALUATION WITH LEVERAGE

THE WACC METHOD

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The WACC Method

1. Determine the free cash flow of the investment

– Exclude interest expenses from the free cash flow

2. Compute the weighted average cost of capital

– Take into account taxes
3. Compute the value of the investment by discounting the
free cash flow of the investment using the WACC.

• The WACC can be used throughout the firm as the

companywide cost of capital for new investments if
– they will not alter the firm’s capital structure (e.g. debt-equity
ratio)
– they are of comparable risk to the rest of the firm

Firms’ Leverage Policies

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Example: Avco
• Assume Avco is considering introducing a new line of
packaging, the RFX Series.
– Avco expects the technology used in these products to become obsolete
after four years. However, the marketing group expects annual sales of
$60 million per year over the next four years for this product line.
– Manufacturing costs and operating expenses are expected to be $25
million and $9 million, respectively, per year.
– Developing the product will require upfront R&D and marketing
expenses of $6.67 million, together with a $24 million investment in
equipment.
• The equipment will be obsolete in four years and will be depreciated via the straight-line
method over that period.
– Avco expects no net working capital requirements for the project.
– Avco pays a corporate tax rate of 40%.

Example: Avco, cont.

• Here is information about capital structure:

• Net debt is 320-20 = 300

• Equity is 300
• The current WACC is 6.8%:

E D 300 300
rwacc  rE  rD (1   c )  (10%)  (6%)(1  0.40)
E  D E  D 600 600
 6.8%

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 Example: Avco – cont.

• We use term “unlevered net income” in row #8 because we exclude interest expenses
from FCFs. Note, however, that leverage can affect FCFs (row #12) through other
channels. For example, leverage can mitigate agency costs and therefore reduce costs
and increase FCFs.
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Example: Avco – cont.

• Avco intends to maintain a similar (net) debt-equity ratio for the

foreseeable future, including any financing related to the RFX project.
• Therefore, it can use the current WACC for the purpose of evaluating this
project.
• The value of the project, including the tax shield from debt, is calculated as
the present value of its future free cash flows:
18 18 18 18
V0L      $61.25 million
1.068 1.0682 1.0683 1.0684

• The NPV of the project is $33.25 million:

$61.25 million – $28 million = $33.25 million

• Note that we intentionally separate the initial investment (FCF in year 0)

from future FCFs.

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Implementing a Constant Debt-Equity
Ratio
• By undertaking the RFX project, Avco adds new assets to the firm with
initial market value $61.25 million.
– Therefore, to maintain its debt-to-value ratio, Avco must add $30.625 million in new debt (50%
× 61.25 = $30.625)
– Assume Avco decides to spend its $20 million in cash and borrow an additional $10.625 million,
resulting in $30.625 million increase in net debt.
– Because only $28 million is required to fund the project, Avco will pay the remaining $2.625
million to shareholders through a dividend (or share repurchase):
$30.625 million − $28 million = $2.625 million

Before: After:

– The market value of Avco’s equity increases by $30.625 million.

– Adding the dividend of $2.625 million, the shareholders’ total gain is $33.25 million.
– Shareholders’ total gain equals to the NPV of this project, suggesting that the value of debt is
not affected by this project.

Implementing a Constant Debt-Equity

Ratio – cont.
• Debt Capacity: The amount of debt at a particular date that is required to
maintain the firm’s target debt-to-value ratio:
Dt  d  Vt L
where d is the firm’s target debt-to-value ratio and VLt is the levered continuation value on
date t (i.e., the present value of the remaining FCF).

• 𝑉 was calculated on slide #9

• 𝑉 = + + =47.41
. . .
• and so on…
• In year t=1:
– The project generates $18 million in free cash flow
– $1.1 million in after-tax interest expense ($30.62*6%*(1-40%))
– $6.92 million is paid to reduce the debt (from $30.62 million to $23.71 million, rounded up)
– The remaining $9.98 million is paid to shareholders (e.g., special dividend or share repurchases)

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WACC Method, Summary
• Our analysis indicates that in order to implement a constant debt-
equity ratio, we have to adjust debt capacity (i.e., the level of net
debt) every time a project generates FCFs.
• Moreover, these changes typically require making payout decisions.

• If these financing actions are not implemented, the actual impact of

the project on firm value will differ from our NPV calculation.

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THE ADJUSTED PRESENT

VALUE METHOD
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The Adjusted Present Value Method
1. Determine the investment’s value without leverage
2. Determine the present value of the interest tax shield
– Determine the expected interest tax shield
– Discount the interest tax shield

• Add the unlevered value to the present value of the interest

tax shield to determine the value of the investment with
leverage (assuming no personal taxes):

V L  APV  V U  PV (Interest Tax Shield)

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Example: Avco
• For Avco, its unlevered cost of capital is calculated as:
𝑊𝐴𝐶𝐶 𝑇 = 0 = 0.5 × 10% + 0.5 × 6% = 8%
𝑟 = 𝑟 = 8%
• The project’s value without leverage is calculated as:
18 18 18 18
VU      $59.62 million
1.08 1.082 1.083 1.084
• The present value of the interest tax shield is (assuming debt capacity is the
same as in the WACC method):

0.73 0.57 0.39 0.20

PV (interest tax shield)      $1.63 million
1.08 1.082 1.083 1.084

V L  V U  PV (interest tax shield)  59.62  1.63  $61.25 million

• The NPV of the project is $33.25 million:
$61.25 million – $28 million = $33.25 million
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The APV Method vs the WACC
Method
• The APV method has some advantages:
– It can be easier to apply than the WACC method when the firm
does not maintain a constant debt-equity ratio.
• That is, we can use any debt capacity (not necessary one that leads to
constant debt-equity ratio).
– The APV approach also explicitly values market imperfections
and therefore allows managers to measure their contribution to
value.
• E.g., we see that equity holders in Avco example capture $1.63 million in
interest tax shield

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THE FLOW-TO-EQUITY
METHOD
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The Flow-to-Equity Method
• A valuation method that calculates the free cash flow
available to equity holders taking into account all payments
to and from debt holders
– The free cash flow that remains after adjusting for interest
payments, debt issuance and debt repayments
FCFE  FCF  (1   c )  (Interest Payments)  (Net Borrowing)

After-tax interest expense

Net Borrowing at Date t  Dt  Dt  1

• The cash flows to equity holders are then discounted using

the equity cost of capital

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Example: Avco

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Example: Avco – cont.

• Because the FCFE represent payments to equity holders, they

should be discounted at the project’s equity cost of capital.
– Given that the risk and leverage of the RFX project are the same as for Avco
overall, we can use Avco’s equity cost of capital of 10.0% to discount the project’s
FCFE.

9.98 9.76 9.52 9.27

NPV (FCFE )  2.62      $33.25 million
1.10 1.102 1.103 1.10 4

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Summary of the Flow-to-Equity

Method
• The FTE method offers some advantages.
– It may be simpler to use when calculating the value of equity
for the entire firm, if the firm’s capital structure is complex and
the market values of other securities in the firm’s capital
structure are not known.
– It may be viewed as a more transparent method for discussing
a project’s benefit to shareholders by emphasizing a project’s
implication for equity.

• The FTE method has a disadvantage.

– One must compute the project’s debt capacity to determine the
interest and net borrowing before capital budgeting decisions
can be made.

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Project-specific risk profile

EXAMPLE

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